Bank of Canada worries about potential for debt shock

OTTAWA (Reuters) - The Bank of Canada warned again about rising household debt on Thursday, saying Canadians could “experience a significant shock if house prices were to reverse”.

A sign warning pedestrians of falling ice from buildings above its path is seen in front of the Bank of Canada building in Ottawa January 17, 2012. REUTERS/Chris Wattie

Last year Canada posted a ratio of debt to income of 153 percent, above that in the United States. The central bank says it is concerned that low interest rates are persuading Canadians to take on too much debt.

In the introduction to the latest edition of the Bank of Canada Review, a collection of articles on the economy and central banking, the bank said there had been a increase in both household indebtedness and real house prices since 2000.

“These facts are interrelated, since rising house prices can facilitate the accumulation of debt. Households could therefore experience a significant shock if house prices were to reverse,” it said.

Canada has not seen the kinds of excesses in other nations such as the United States, where homeowners took advantage of rising prices to remortgage properties and were then left stranded by the crash.

Finance Minister Jim Flaherty also warned Canadians they should prepare for the impact of higher borrowing costs.

“On the housing market, we’ve seen some moderation of late in good parts of the residential mortgage market. We watch that carefully, particularly the condominium market,” told reporters in Toronto.

“Interest rates are going to go up ... people need to be sure that they can afford higher mortgage interest, for example. It isn’t necessary for everyone to have the most expensive house they can possibly buy.”

PRICE FALL WOULD HIT SPENDING

In Canada, the large increase in total household debt since 1999 consists primarily of home equity extraction, which rose from 2.2 percent of disposable income in 1999 to a peak of 9 percent in 2007.

“The evidence indicates that a significant share of borrowed funds from home-equity extraction was used to finance consumption and home renovation in Canada from 1999 to 2010,” an article in the review said.

“Such indebtedness constitutes an important source of risk to household spending, since it makes households more vulnerable to a potential decline in house prices,” it added.

In 2009, net draws on home equity lines of credit represented almost a quarter of the total increase in household debt. The bank said the results of one of its simulations suggested a 10 percent decline in house prices could generate a peak drop in consumption of about 1 percent.

Another article suggested there was more pain to come for homeowners, and the current increase in values could not be maintained over the long term.

It said that growth in income and population could largely explain the rising trend in house prices over the last 30 years, but other factors had contributed to gains over the last decade.

These included declining long-term interest rates, expectations of rising housing prices and the liquidity of the housing market.

The article said these factors “are associated with the medium-run tendency of house prices to rise faster than their long-term trend for a number of years and then subsequently adjust back to trend.”

With additional reporting by Jennifer Kwan and Jeffrey Hodgson in Toronto